March 15, 2011

 By Whitney Kvasager

Credit ratings would no longer be required in assessing what securities money market funds can buy if a newly proposed SEC rule is adopted. Instead, the proposal would hand all responsibility for determining whether a security is eligible for purchase to fund boards or their delegate, usually the advisers.

Though SEC commissioners voted unanimously to propose the rules, one voiced “serious misgivings” that echoed criticism numerous industry observers made in 2008, when the SEC proposed similar rules. The SEC never acted on its earlier proposals; it is considering the issue this time to comply with the Dodd-Frank Act, which requires that the commission delete all references and requirements related to credit ratings in regulations and replace them with other
standards of creditworthiness.

Among other changes, the SEC’s proposals would amend Rule 2a-7, which establishes what securities a money market fund is allowed to purchase, in part by setting the level of credit rating a security must receive in order to be eligible. Money funds may invest in securities with the highest credit rating; they may also invest in securities with the second-highest rating, but those securities can make up only 3% of a fund’s assets. Money fund boards or their delegates must
also determine that every security presents minimal credit risk regardless of the rating.

Under the new proposal, a credit rating would no longer be required. Instead, a security would only be eligible if a money market fund board or its delegate determines that it has the “highest capacity to meet its short-term financial obligations.” That standard would be analogous to receiving the highest credit rating, and there would be no limit on the amount the fund could purchase of such securities. The proposal would also establish a second tier of securities a money fund could invest in: those that present minimal risk but do not meet the criteria of a first-tier security. As in the current rule, the proposed rule would cap investments in second-tier securities at 3%.

Comments on the proposed amendments are due to the SEC by April 25.

Industry observers weighing in on the proposal were uniformly critical of the ideas, as much of the industry has been when similar proposals have been made. As they have done previously, critics of the most recent proposal say it removes an important safeguard for money market funds that could encourage inconsistent investment behavior within the money fund industry. Commissioner Luis Aguilar voiced his concerns about the proposal at the SEC’s meeting earlier this month, calling the creation of an appropriate substitute for credit ratings an “impossible challenge.” Among other points, Aguilar said he has “serious misgivings because it appears no appropriate substitute has been identified. The cost of implementing today’s proposal seems to far outweigh the benefits for industry participants and investors alike.”

“Eliminating the credit rating requirement and leaving only the internal, subjective standard is to take away a vital investor protection. Removing this objective, external determination will create an opportunity for those that will chase yield at the expense of investing in the highest-quality
securities,” Aguilar said.

He continued: “It is clear that the commission contemplates that money market funds' boards will continue to use credit ratings as currently required. Of course, without the requirement, there can be no guarantee that will be the case. This is a contradiction on its face and sends fund boards a mixed message. Moreover, eliminating the objective baseline determination exposes investors to more rather than less risk – this runs counter to the entire philosophy of Rule 2a-7.”

Others in the industry had similar concerns and said an ideal solution would be for Congress to remove its blanket ban on references to rating agencies, though they recognized that was unlikely. Many agreed that if the proposal is adopted, practically all boards would delegate the task of assessing securities to the adviser. But the change would still impact directors because they would have to make time in their already packed meetings to understand how the adviser is making the assessments.

“Boards are not in a good position to be making determinations of credit quality on a day-to-day basis of the funds they oversee. In virtually every imaginable circumstance, they will delegate to the adviser,” said David Smith, executive VP and general counsel of Mutual Fund Directors Forum.

“The board is going to have to have some understanding and comfort about how the delegate, the adviser, makes these determinations. At some level they’ve always done that, but the possible twist is that the commission’s commentary indicates that boards and advisers can continue to look to credit ratings. So directors will have to know how the credit ratings will factor into the analysis of advisers and how they’re going to determine how credible the ratings are.”

Boards may also want to address Aguilar’s concern that removing credit rating requirements could invite a more aggressive investment approach, said Joan Ohlbaum Swirsky, of counsel at Stradley Ronon.

“Boards may feel that the fund is more vulnerable to reaching for yield because there’s no protective floor, so the board might want to ask if the adviser has a floor and what that is,” she said, adding that investors may feel more comfortable with a minimum set requirement, like a minimum credit rating, for the securities it purchases.

The proposal also opens the door to the opposite concern, said Todd Cipperman, investment management attorney at Cipperman & Company. He said it’s more likely that boards would swing in the other direction.

“I don’t think as a practical matter a board would reach for yield, certainly not an independent director,” he said. “It’s a really weird thing because in the fund industry it’s hard to harangue: ‘Let's make this more conservative.’ But money market funds are competing against non-fund instruments. They’re already at historically low yields. There are precious few money market fund providers. I think essentially the rule change is going to make these funds non-competitive. I’m not so sure the answer is to not use credit ratings. I think the answer would be to regulate the credit rating industry.”

Swirsky noted that the proposal would likely draw largely critical comments from the investment community, as did the similar proposals three years ago.

“I think there was broad opposition to a very similar proposal in 2008, and I expect there is going to be opposition again,” Swirsky said. “In Rule 2a-7, there are two levels of testing, an objective test and a subjective test. The question is, why is the SEC departing from that two-level test for quality?”

The proposed amendments to Rule 2a-7 are among several the SEC will consider in the coming months as it works to implement the Dodd-Frank Act’s requirement to amend regulations that contain credit rating references. Dodd-Frank removes a reference to credit ratings from a key section of the ’40 Act and replaces it with a reference to “such standards of creditworthiness as the commission shall adopt.”

The proposal comes at a time of uncertainty for money market funds. Among other things, the industry is waiting for the SEC’s meetings about the recently released report on money fund reforms from the President’s Working Group on Financial Markets. It’s also waiting to see how other parts of the Dodd-Frank Act will impact the money market fund industry.

Another pressure is the persistently low interest rate environment that has kept money fund yields low. Total money market fund assets fell by $1.5 billion during the week ending March 1, with total fund assets settling at $2.7 trillion, according to MoneyNet.

Many fund families have responded by closing down certain money market funds; Phoenix, Merrimac, Delaware, Wells Fargo, Prudential, Goldman Sachs, AARP and Eaton Vance have all liquidated money market funds this year.